In this Section:LIFE

How To Tell Owners That Perm Is Not A Black Hole

Your business-owner clients have many financial needs, and permanent life insurance may be the solution. But they may be resistant to buying it.

Most entrepreneurs feel like the premiums they pay get sucked down a black hole never to return. They perceive that any policy equity is off-limits during their lifetime. Help them understand the truth.

Owners can tap into the policy’s cash value at any time for any reason via loan or withdrawal. Whereas many of your W-2 employee clients may head for the hills when they hear the words “loan” or “borrow,” most entrepreneurs already embrace the concept of using OPM (other people’s money).

A life insurance loan may be the safest and most flexible way to use OPM. Their full cash value balance continues growing safely as if it never left their policy because — it never leaves their policy! All life insurance companies contractually agree to provide a private loan against policy equity on a no-questions-asked basis since they’ll be holding the cash value as collateral.

Yes, the policyholder will owe interest, but they get to choose if and when they pay it. A life insurance loan is against the policy’s death benefit, so the loan isn’t due until death. That’s why there’s no rigid payment structure as long as the cash value exceeds the loan amount. They should responsibly schedule some periodic loan maintenance, but the cash value growth may keep pace with any accruing loan interest or possibly even outrun it.

Certain indexed universal life policies even offer contractually locked loan rates in the 5-6 percent range for the life of the policy. Business owners really love this concept of locking in their ability to access capital at 5-6 percent while still being able to earn double-digit returns on their cash value.

Who Should Own The Policies?

Although it may seem simpler to have the operating company itself own the life insurance policies backing the buy-sell agreement, it may be more tax efficient to have the individual owners take out policies on each other.

If the company itself receives the death benefit and uses the proceeds to buy out the deceased owner’s heirs, the company gets no increase in basis for the ownership it paid for. This type of buy-sell agreement is commonly referred to as a stock redemption plan or agreement. However, it’s more appropriate to refer to this structure as an “entity redemption” because limited liability corporations are made up of units instead of stock.

On the other hand, in a cross-purchase agreement, the owners personally take out policies on each other. Because the surviving owners would receive the death benefits personally and then use the proceeds to buy the deceased owner’s stock or units, their new basis in the company increases by the amount they paid. Down the road, if the company is sold for a capital gain, the amount deemed as basis in their partner’s stock or LLC units would not be taxable.

I’ve found that business owners deem this huge possible tax benefit worth the extra complication unless there are more than three owners. With three owners, six policies are needed (since each owner needs a policy on each other). With four owners, 12 separate life insurance policies are needed. With five owners, 20 policies, and so on.

I usually prefer that any permanent policies be moved off the operating business balance sheet anyway. That’s where most of the risk resides, and the owners are much less likely to be sued personally. Also, in many states, life insurance may be an exempt asset protected from creditors when held personally.

One way to get the best features of both an entity redemption and a cross-purchase plan is to have the owners set up a separate buy-sell LLC that owns one policy on each owner. The LLC language needs to be structured so that only the surviving owners’ capital accounts receive their proportionate share of any death benefit. Then they will have manufactured the necessary separation to get the benefits of a cross-purchase agreement within the centralized simplicity of an entity redemption plan.

Taking the LLC concept a step further, it can also act as the LLC’s own private lending or leasing company. Having the separate LLC stockpile cash value and/or purchase expensive equipment using policy loans can turbocharge what would otherwise be stagnant assets.

This separate structure for the assets may also better insulate the owners from lawsuit. In many states, a “charging order” is the only way a creditor can attach any LLC interests owned by the defendants. This means that someone who has won a lawsuit against our business owner clients would be entitled to any distributions made from their buy-sell LLC lending company. However, the creditors can’t force the owners to give up assets from within the LLC when a charging order is all they have.

Show your entrepreneurs how this helps protect their most prized asset — their business. Show them how the multifaceted hedged benefits are easily worth the cost. Better yet, show them how they can protect themselves while building a tax-favored asset they can use leading up to retirement and beyond.